This article has been adapted from Fool UK, our sister site across the pond.
When it comes to having the ear of the boardroom, few advisers come more influential than consulting giant McKinsey. Simply put, when McKinsey thinks that there's an argument for doing something, it takes a bold chief executive to simply ignore the firm's high-priced advice.
So it's worth keeping an eye out for the latest thinking to circulate among McKinsey consultants -- especially when that thinking is driven by the firm's extensive research program.
So I read with interest a research-backed McKinsey study arguing that too many companies tended to blithely pay out dividends without giving enough thought to the merits of share buybacks instead.
The McKinsey argument in a nutshell: In theory, there's no difference between the two ways of returning cash to shareholders -- and buybacks offer much greater flexibility in terms of timing and amount.
Too much cash
And for sure, companies have to do something with their surplus cash. As the authors convincingly argue, there simply isn't enough scope for investing it internally:
A company earning $1 billion a year in after‑tax profits, with a 25% return on invested capital (ROIC) and projected revenue growth of 5% a year, needs to invest about $200 million annually to continue growing at the same rate. That leaves $800 million of additional cash flow available for still more investment or returning to shareholders.
Yet finding $800 million of new value‑creating investment opportunities every year is no simple task -- in any sector of the economy. Furthermore, at a 25% ROIC, the company would need to increase its revenues by 25% a year to absorb all of its cash flow.
In other words, there's no alternative to returning a substantial amount of cash to shareholders. So the question is: how?
Enter the dividend
Traditionally, dividends have been a popular way of returning cash to shareholders. Not for nothing, in short, are some of the world's very largest businesses also its biggest dividend payers.
Here in the UK, for instance, consider the hefty payouts from such FTSE 100 stalwarts as Vodafone (NYSE: VOD ) and GlaxoSmithKline (NYSE: GSK ) .
But investors have a strong preference for a "progressive" -- that is, increasing -- dividend policy, which can be hard to maintain when times are hard. Dividend-cutters, as we all know, are typically punished mercilessly. And it can take years for a former dividend-cutter to return to favor.
Hence the attractions of a buyback program. It doesn't affect the record of dividend payments, doesn't upset investors when it's suspended, and can be implemented and extended as surplus cash arises.
The trouble is, investors routinely complain about buybacks. It may make no difference from the company's point of view -- but from the investors' point of view, it's most certainly one less dividend check dropping onto the doormat
Worse, it's not difficult to spot companies that seem to get their buyback timing awfully wrong -- buying back shares when they are at their most expensive, for instance. The top of the cycle might be when the most surplus cash arises, but it's also typically a poor time to buy back and cancel shares.But be that as it may, McKinsey's research is adamant. Taking the market as a whole, the firm says:
"Does it matter whether distributions take the form of dividends or share repurchases? Empirically, the answer is no. Whichever method is used, earnings multiples are essentially the same for companies when compared with others that have similar total payouts. Total returns to shareholders are also the same regardless of the mix of dividends and share repurchases."
Use with caution
So where does that leave us? Perhaps predictably, the McKinsey consultants fall short of arguing that all dividends are bad. They do, though, counsel caution among companies that pay them:
"Managers should employ dividends only when they are certain they can continue to do so. Even increasing a dividend sends signals to investors that managers are confident that they will be able to continue paying the new, higher dividend level."
Buybacks, on the other hand, return cash to shareholders without signaling anything regarding future expectations: "Share repurchases also signal confidence but offer more flexibility because they don't create a tacit commitment to additional purchases in future years."
In other words, buybacks offer greater flexibility and lower risk -- and we, as investors, should welcome them if we believe that future earnings and dividend levels might in any way be compromised by unexpected events.
I'm certainly not panicking. My dividend stream isn't going to dry up tomorrow, and it quite probably won't dry up at all
Nevertheless, a growing number of FTSE 100 dividend payers have significant trans-Atlantic shareholdings and business interests. And once a business fashion takes hold, it may be difficult for them to resist it.
In short, it's a case of "watch this space.
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